Learn the Basics of Investing in High Yield Bonds

High yield bonds are often referred to as “junk bonds,” but that term is a relic of a past era. Today, high yield bonds are a mature, robust asset class that can provide a number of advantages to investors who understand the risks.

What are High Yield Bonds?

High yield bonds are the bonds issued by companies with credit ratings that are beneath investment-grade. An example of an investment grade company would be Microsoft or Exxon Mobil, large multinational firms with massive recurring revenues and a ton of cash on their balance sheets. Both companies actually have higher credit ratings than the U.S. government, since there is no chance that they will default, or in other words, fail to make their interest and principal payments on time.

In contrast, high-yield bonds are issued by companies with outlooks that are questionable enough to prevent their debt from being ranked investment grade. High yield companies might have high levels of debt, shaky business models, or negative earnings.

As a result, there is a greater likelihood that they could default. Such companies, therefore, earn lower credit ratings and investors demand higher yields to own their bonds. The reason why riskier bonds typically pay higher yields is discussed in my article The Relationship Between Risk and Yield in the Bond Market.

The Risks of High-Yield Bonds

For individuals who invest in high yield via mutual funds or exchange-traded funds (rather than individual bonds), default isn’t the primary consideration. The historical annual default rate for high yield is about 4% per year, which means that most funds or ETFs that invest in the sector don’t see a major performance impact from defaults in any given year.

Instead, the primary risk is the elevated volatility of high yield bonds compared to other areas of the bond market. High yield bonds have performed well over time, but the asset class can also fall extremely quickly when the market environment turns sour.

The most extreme recent example occurred in 2008 when the U.S. financial crisis hit the markets in full force. From August 29 to October 27 of that year, the high yield market lost over 25% of its value. This was a very unusual case, but it illustrates the potential short-term risks involved with an investment in high yield.

Strong Historical Returns

The periodic sell-offs such as the one that occurred in 2008 haven’t dampened the long-term performance of high yield bonds. In the ten-year period ended August 31, 2012, the Credit Suisse High Yield Index delivered an average annual total return of 10.26% - better than all segments of the fixed income market except emerging market bonds.

During that same time period, investment-grade bonds (as measured by the Barclays Aggregate US Bond Index) returned 5.48% per year on average, while U.S. stocks (as gauged by the S&P 500 Index) returned 6.51%.

Not only did high yield outperform stocks during this time period, but it did so with about half of the volatility – meaning that the risk/reward trade-off was outstanding on a relative basis. It should also be noted that high-yield bonds delivered positive returns 23 of the 28 calendar years through 2011 according to Lipper.

In terms of yield, the asset class has averaged an advantage of about six percentage points relative to U.S. Treasuries over time. However, this advantage – or yield spread – has moved within a huge range. It fell as low as 2.5 – 2.6 percentage points in 1997 and again in 2007, and it spiked as high as 21 percentage points in the financial crisis of 2008.

High yield bonds tend to perform best during periods of economic expansion and high investor confidence. Conversely, the asset class generally performs poorly when the risk of recession is high and/or investors are not comfortable taking a risk.

Interest rate movements don’t have as much of an impact on high yield bonds as they do other areas of the bond market since their yield advantage means that a quarter-point move in Treasuries have less of an effect on yield spreads as it would on bonds with lower yields. This by the asset manager Alliance Bernstein provides more detail on this phenomenon.

A year-by-year record of high yield bonds' performance, along with a comparison of the returns stack up against those of both stocks and investment-grade bonds, is available .

Who Invests in High Yield Bonds?

High yield bonds are generally considered to offer a middle ground between stocks and bonds. While they are fixed income securities, high yield bonds also have higher volatility than most segments of the bond market, and over time their performance tends to track much closer to the stock market than it does investment grade bonds.

The asset class is, therefore, appropriate for someone who is looking for high income and the potential for long-term capital appreciation, but who can also withstand the risk and – most important – has the ability to hold on to their investment for three to five years. Due to their elevated volatility, high yield bonds aren’t appropriate for investors with short-term time frames or a low tolerance for risk.

How to Invest

Sophisticated investors have the option of buying individual high yield bonds through a broker. However, this is a labor-intensive process that involves a high level of knowledge and research. Most investors choose to access the sector via either mutual funds or ETFs. Morningstar has the full list of high yield bond funds, with their historical returns. The two largest high yield ETFs are SPDR Barclays Capital High Yield Bond ETF (JNK) and iShares iBoxx $ High Yield Corporate Bond Fund (HYG). Other ETFs that invest in the sector are:

iShares iBoxx $ High Yield Corporate Bond Fund (HYG)

SPDR Barclays High Yield Bond ETF (JNK)

SPDR Barclays Capital Short Term High Yield Bond ETF (SJNK)

iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)

PIMCO 0-5 Year U.S. High Yield Corporate Bond Index Fund (HYS)

PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB)

Peritus High Yield ETF (HYLD)

Market Vectors Fallen Angel Bond ETF (ANGL)

First Trust High Yield Long/Short ETF (HYLS)

Market Vectors Treasury-Hedged High Yield Bond ETF (THHY)

ProShares High Yield-Interest Rate Hedged ETF (HYHG)

Guggenheim BulletShares 2013 High Yield Corporate Bond ETF (BSJD)

Guggenheim BulletShares 2014 High Yield Corporate Bond ETF (BSJE)

Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (BSJF)

Guggenheim BulletShares 2016 High Yield Corporate Bond ETF (BSJG)

Guggenheim BulletShares 2017 High Yield Corporate Bond ETF (BSJH)

Guggenheim BulletShares 2018 High Yield Corporate Bond ETF (BSJI)

Guggenheim BulletShares 2019 High Yield Corporate Bond ETF (BSJJ)

Guggenheim BulletShares 2020 High Yield Corporate Bond ETF (BSJK)

Investors also can gain access to international high yield bonds via the following ETFs:

iShares Global High Yield Corporate Bond Fund (GHYG)

Market Vectors International High Yield Bond Fund (IHY)

iShares Global ex USD High Yield Corporate Bond Fund (HYXU)

PowerShares Global Short Term High Yield Bond Portfolio (PGHY)

Market Vectors Emerging Markets High-Yield ETF (HYEM)

iShares Emerging Markets High Yield Bond Fund (EMHY)

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always research carefully before you invest.